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Review of Quantitative Finance and Accounting

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01.01.2009 | Original Research

The influence of managerial incentives on the resolution of financial distress

verfasst von: Dong-Kyoon Kim, Chuck C. Y. Kwok

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 1/2009

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Abstract

This study investigates the influence of managerial incentives on the resolution of financial distress. Our model predicts that when creditors and equityholders prefer different resolution methods, the likelihood of choosing Chapter 11 over private renegotiation is related to the ownership structure of the distressed firm. Empirical test results using a sample of 81 voluntary Chapter 11 firms and 65 private workout firms support the model’s prediction. We show that managerial ownership is positively related to the incidence of Chapter 11 filing when there is conflict between equityholders and creditors over the choice between Chapter 11 and a private renegotiation. Consistent with prior literature, we also find that the choice of resolution methods depends on the extent of creditor holdout problems and the level of economic distress. We also performed the analysis of a subsequent 5 years of post-distress performance for all sample firms. The majorities of firms that file for Chapter 11 lose their independence and are either acquired or liquidated. However, more than half of firms in private workouts survived as independent firms.

Vorheriger Artikel Non-audit service and auditor independence: an examination of the Procomp effect

Nächster Artikel Performance persistence and its influence on money and investor flows into Spanish pension plans

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Several previous studies, such as Bebcchuck and Chang (1992) and Berovitch and Israel (1998), analyze the bankruptcy decision and debt contract renegotiation of distressed firms by focusing on the conflict of interest between owner/manager and creditors. However those studies do not consider the conflicts of interest between managers and equityholders in their theoretical frameworks by assuming that managers act in the equityholders’ interests. Our study explicitly considers the situation where the conflict of interest between managers and equityholders can arise in our analysis. We also conduct an empirical analysis.

The sample period of our study for the onset of reorganization is from 1992 to 1998. However, we also analyze the subsequent five-year post-distress performance for all sample firms to examine the outcomes of reorganization. In effect, our sample period covers the years of 1997–2003. Studies such as Kahl (2002) and Turetsky and McEwen (2002) analyze post-performance of distressed firms.

In our framework, D is assumed to be the maximum value creditors can take in reorganization.

Deadweight costs in a private workout are transactions costs incurring in reorganization due to creditor holdout problems in a distressed firm. Gilson (1997) broadly defined the transaction costs as a major impediment to voluntary corporate restructuring. Bankruptcy costs are incurred in Chapter 11 because Chapter 11 bankruptcy involves significant administrative costs and other economic losses (Gilson et al. 1990).

See Gilson et al. (1990), Gilson (1991), and Wruck (1990) for details.

We assume that there exists minimum equity value that can be preserved as long as a distressed firm is in reorganization by negotiating with creditors (i.e., both δ(B) and δ(W) are positive).

Several studies identify the major sources of the equityholders’ ability to obtain value and parameters that determine how much they will obtain under Chapter 11, even though the firm is insolvent (e.g., Franks and Torous 1989; Bebchuk and Chang 1992; Mooradian 1994). The sources are option to delay and incentive to take risky projects, which may incur significant financial distress costs to creditors. By avoiding these options, equityholders can obtain part of these savings at the expense of creditors. Betker (1995) also mentions that equityholders can directly affect a firm’s reorganization procedure in a Chapter 11 case by forming an equity committee.

A more complete algebraic analysis that derives parameter values that give rise to a conflict is provided in the Appendix.

This explanation is consistent with the findings in Franks and Torous (1994). They find larger equity deviations from absolute priority at reorganization when the face value of creditors’ claim (D) is close to the value of the firm at reorganization. This finding suggests that the institutional characteristics of Chapter 11 are used as bargaining power by equityholders, which leads creditors to offer equityholders more when the option to delay in Chapter 11 is close to or at-the-money (i.e., the firm’s reorganization value is close to D).

Gilson and Vetsuypens (1993) show that 10% of their sample explicitly tied the management compensation to creditors’ value. Managers are either awarded financial claims similar to those held by creditors, or paid a bonus based on how much cash creditors received under the firm’s reorganization plan.

Gilson (1989) shows that 20 management changes out of 176 management changes for financially distressed firms are initiated by bank lenders.

Some firms adopt debt restructuring for the strategic purpose although they are not in the financial distress. These firms are excluded from the sample.

This procedure for gathering the sample is common for the related studies (e.g., Gilson et al. 1990; Charterjee et al. 1996). However, other studies, such as Sun (2007), use different method to collect the sample for distressed firms.

A necessary condition for firms that remain independent is that the firm is not in Chapter 11, is not in default, and not negotiating to restructure its debt to avoid a default, at least for 5 years after the onset of financial distress.

We compare the sample of our paper with Kahl (2002) and find that the samples in Kahl (2002) and our paper are quite comparable. Kahl (2002) uses a sample of 102 firms which consist of Chapter 11s (56 firms, 54.9%) and private renegotiation firms (46 firms, 45.1%) during a period of 1979–1983. The paper analyzed the debt restructuring process from the onset of restructuring to the outcomes of restructuring. The overall average rate of sample (the number of the sample observations divided by the number of sample years) in Kahl (2002) is 20.2 (105/5) (Chapter 11s: 11.2, and private workouts: 9.2). The overall average of our sample is 20.9 (146/7) (Chapter 11s (55.4% of the sample): 11.6 and private workouts (44.5% of the sample): 9.3).

Industry-adjusted EBITDA to total assets ratio is constructed by subtracting the median EBITDA/total assets of all other Compustat firms with the same 3-digit SIC code from a firm’s EBITDA/total assets.

V is the value that the firm would have such that if the firm is not expected to incur the deadweight costs in reorganization.

This analysis is based on the reviewer’s suggestions.

Gilson et al. (1990) explain why assets are more likely to be sold in Chapter 11 than in private negotiations. For instance, the firm has more power over the disposition of the firm’s assets owing to automatic stay provision.

The market to value of assets ratio is constructed using data from COMPUSTAT or Compact Disclosure data base and is calculated as (book value of assets–book value of equity + market value of equity)/book value of assets. When applicable, these figures are those that most closely predate the beginning of firms’ debt restructuring or bankruptcy.

In his model, Mooradian (1994) shows that the institutional characteristics of Chapter 11 filing provide an incentive for economically inefficient firms to reorganize under Chapter 11 rather than mimic out-of-court reorganization. Chapter 11 can be a screening device which separates inefficient firms from efficient firms, enabling efficient firms to renegotiate and continue where they would otherwise be liquidated.

Since the sample size in our study is quite small (146 firms), results from the logistic regression are more likely to be vulnerable to the effect of outliers. However, based on the statistics for RStudent, DFFITS, and DEBETAS, overall, there are no observations which exhibit an extraordinary behavior.

We also estimate the logistic regressions using CEO ownership. Results show that there are no qualitative changes in the coefficients of the explanatory variables.

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Titel: The influence of managerial incentives on the resolution of financial distress
verfasst von: Dong-Kyoon Kim
Chuck C. Y. Kwok
Publikationsdatum: 01.01.2009
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 1/2009
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-008-0085-8

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